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Chapter 2 World Trade: An Overview 1ContentsChapter 1 Introduction 1Overview of Section I: International Trade Theory . 3Chapter 2 World Trade: An Overview . 5Chapter 3 Labor Productivity and Comparative Advantage: The Ricardian Model 8Chapter 4 Resources, Comparative Advantage, and Income Distribution. 12Chapter 5 The Standard Trade Model 16Chapter 6 Economies of Scale, Imperfect Competition, and International Trade 21Chapter 7 International Factor Movements 26Overview of Section II: International Trade Policy . 30Chapter 8 The Instruments of Trade Policy . 32Chapter 9 The Political Economy of Trade Policy. 37Chapter 10 Trade Policy in Developing Countries. 42Chapter 11 Controversies in Trade Policy 45Overview of Section III: Exchange Rates and Open-Economy Macroeconomics. 49Chapter 12 National Income Accounting and the Balance of Payments 51Chapter 13 Exchange Rates and the Foreign-Exchange Market: An Asset Approach 57Chapter 14 Money, Interest Rates, and Exchange Rates 64Chapter 15 Price Levels and the Exchange Rate in the Long Run. 70Chapter 16 Output and the Exchange Rate in the Short Run . 76Chapter 17 Fixed Exchange Rates and Foreign-Exchange Intervention 84Overview of Section IV: International Macroeconomic Policy . 92Chapter 18 The International Monetary System, 18701973 94Chapter 19 Macroeconomic Policy and Coordination Under Floating Exchange Rates . 99Chapter 20 Optimum Currency Areas and the European Experience 107Chapter 21 The Global Capital Market: Performance and Policy Problems 112Chapter 2 World Trade: An Overview 2Chapter 22 Developing Countries: Growth, Crisis, and Reform 117Chapter 2 World Trade: An Overview 3Chapter 1Introduction Chapter OrganizationWhat is International Economics About?The Gains from TradeThe Pattern of TradeHow Much TradeBalance of PaymentsExchange-Rate DeterminationInternational Policy CoordinationThe International Capital MarketInternational Economics: Trade and Money Chapter OverviewThe intent of this chapter is to provide both an overview of the subject matter of international economics and to provide a guide to the organization of the text. It is relatively easy for an instructor to motivate the study of international trade and finance. The front pages of newspapers, the covers of magazines, and the lead reports on television news broadcasts herald the interdependence of the U.S. economy with the rest of the world. This interdependence may also be recognized by students through their purchases of imports of all sorts of goods, their personal observations of the effects of dislocations due to international competition, and their experience through travel abroad. The study of the theory of international economics generates an understanding of many key events that shape our domestic and international environment. In recent history, these events include the causes and consequences of the large current account deficits of the United States; the dramatic appreciation of the dollar during the first half of the 1980s followed by its rapid depreciation in the second half of the 1980s; the Latin American debt crisis of the 1980s and the Mexican crisis in late 1994; and the increased pressures for industry protection against foreign competition broadly voiced in the late 1980s and more vocally espoused in the first half of the 1990s. More recently, the financial crisis that began in East Asia in 1997 and spread to many countries around the globe and the Economic and Monetary Union in Europe have highlighted the way in which various national economies are linked and how important it is for us to understand these connections. At the same time, protests at global economic meetings have highlighted opposition to globalization. The text material will enable students Chapter 2 World Trade: An Overview 4to understand the economic context in which such events occur.Chapter 2 World Trade: An Overview 5Chapter 1 of the text presents data demonstrating the growth in trade and increasing importance of international economics. This chapter also highlights and briefly discusses seven themes which arise throughout the book. These themes include: (1) the gains from trade; (2) the pattern of trade;(3) protectionism; (4) the balance of payments; (5) exchange rate determination; (6) international policy coordination; and (7) the international capital market. Students will recognize that many of the central policy debates occurring today come under the rubric of one of these themes. Indeed, it is often a fruitful heuristic to use current events to illustrate the force of the key themes and arguments which are presented throughout the text.Chapter 2 World Trade: An Overview 6Overview of Section I:International Trade TheorySection I of the text is comprised of six chapters:Chapter 2 World Trade: An OverviewChapter 3 Labor Productivity and Comparative Advantage: The Ricardian ModelChapter 4 Resources, Comparative Advantage, and Income DistributionChapter 5 The Standard Trade ModelChapter 6 Economies of Scale, Imperfect Competition, and International TradeChapter 7 International Factor Movements Section I OverviewSection I of the text presents the theory of international trade. The intent of this section is to explore the motives for and implications of patterns of trade between countries. The presentation proceeds by introducing successively more general models of trade, where the generality is provided by increasing the number of factors used in production, by increasing the mobility of factors of production across sectors of the economy, by introducing more general technologies applied to production, and by examining different types of market structure. Throughout Section I, policy concerns and current issues are used to emphasize the relevance of the theory of international trade for interpreting and understanding our economy.Chapter 2 gives a brief overview of world trade. In particular, it discusses what we know about the quantities and pattern of world trade today. The chapter uses the empirical relationship known as the gravity model as a framework to describe trade. This framework describes trade as a function of the size of the economies involved and their distance. It can then be used to see where countries are trading more or less than expected. The chapter also notes the growth in world trade over the previous decades and uses the previous era of globalization (pre-WWI) as context for todays experience.Chapter 3 introduces you to international trade theory through a framework known as the Ricardian model of trade. This model addresses the issue of why two countries would want to trade with each other. This model shows how mutually-beneficial trade arises when there are two countries, each with one factor of production which can be applied toward producing each of two goods. Key concepts are introduced, such as the production possibilities frontier, comparative advantage versus absolute advantage, gains from trade, relative prices, and Chapter 2 World Trade: An Overview 7relative wages across countries.Chapter 4 introduces what is known as the classic Heckscher-Ohlin model of international trade. Using this framework, you can work through the effects of trade on wages, prices and output. Many important and intuitive results are derived in this chapter including: the Rybczynski Theorem, the Stolper-Samuelson Theorem, and the Factor Price Equalization Theorem. Implications of the Heckscher-Ohlin model for the pattern of trade among countries are discussed, as are the failures of empirical evidence to confirm the predictions of the theory. The chapter also introduces questions of political economy in trade. One important reason for this addition to the model is to consider the effects of trade on income distribution. This approach shows that while nations generally gain from international trade, it is quite possible that specific groups within these nations could be harmed by this trade. This discussion, and related questions about protectionism versus globalization, becomes broader and even more interesting as you work through the models and different assumptions of subsequent chapters.Chapter 5 presents a general model of international trade which admits the models of the previous chapters as special cases. This “standard trade model” is depicted graphically by a general equilibrium trade model as applied to a small open economy. Relative demand and relative supply curves are used to analyze a variety of policy issues, such as the effects of economic growth, the transfer problem, and the effects of trade tariffs and production subsidies. The appendix to the chapter develops offer curve analysis.While an extremely useful tool, the standard model of trade fails to account for some important aspects of international trade. Specifically, while the factor proportions Heckscher-Ohlin theories explain some trade flows between countries, recent research in international economics has placed an increasing emphasis on economies of scale in production and imperfect competition among firms. Chapter 6 presents models of international trade that reflect these developments. The chapter begins by reviewing the concept of monopolistic competition among firms, and then showing the gains from trade which arise in such imperfectly competitive markets. Next, internal and external economies of scale in production and comparative advantage are discussed. The chapter continues with a discussion of the importance of intra-industry trade, dumping, and external economies of production. The subject matter of this chapter is important since it shows how gains from trade arise in ways that are not suggested by the standard, more traditional models of international trade. The subject matter also is enlightening given the increased emphasis on intra-industry trade in industrialized countries.Chapter 7 focuses on international factor mobility. This departs from previous chapters which assumed that the factors of production available for production within a country could not leave a countrys borders. Reasons for and the effects of international factor mobility are discussed in the context of a one-factor (labor) production and trade model. The analysis of the international mobility of labor motivates a further discussion of international mobility of capital. The international mobility of capital takes the form of international borrowing and lending. This facilitates the discussion of inter-temporal production choices and foreign direct investment behavior.Overview of Section II: International Trade Policy 8Chapter 2World Trade: An Overview Chapter OrganizationWho Trades with Whom?Size Matters: the Gravity ModelThe Logic of the Gravity ModelUsing the Gravity Model: Looking for AnomaliesImpediments to Trade: Distance, Barriers, and BordersThe Changing Pattern of World TradeHas the World Gotten SmallerWhat Do We Trade?Service OutsourcingDo Old Rules Still Apply?Summary Key ThemesBefore entering into a series of theoretical models that explain why countries trade across borders and the benefits of this trade (Chapters 311), Chapter 2 considers the pattern of world trade which we observe today. The core idea of the chapter is the empirical model known as the gravity model. The gravitymodel is based on the observations that: (1) countries tend to trade with other nearby economies and(2) countries trade is proportional to their size. The model is called the gravity model as it is similar in form to the physics equation that describes the pull of one body on another as proportional to their size and distance.The basic form of the gravity equation is Tij A Yi Yj/Dij. The logic supporting this equation is that large countries have large incomes to spend on imports and produce a large quantity of goods to sell as exports. This means that the larger either trade partner, the larger the volume of trade between them. At the same time, the distance between two trade partners can substitute for the transport costs that they face as well as proxy for more intangible aspects of a trading relationship such as the ease of contact for firms. This model can be used to estimate the predicted trade between two countries and look for anomalies in trade patterns. The text shows an example where the gravity model can be used to demonstrate the Overview of Section II: International Trade Policy 9importance of national borders in determining trade flows. According to many estimates, the border between the U.S. and Canada has the impact on trade equivalent to roughly 2000 miles of distance. Other factors, such as tariffs, trade agreements, and common language can all affect trade and can be incorporated into the gravity model.Overview of Section II: International Trade Policy 10The chapter also considers the way trade has evolved over time. While people often feel that the modern era has seen unprecedented globalization, in fact, there is precedent. From the end of the 19th century to World War I, the economies of different countries were quite connected. Trade as a share of GDP was higher in 1910 than 1960, and only recently have trade levels surpassed the pre World War trade. The nature of trade has change though. The majority of trade is in manufactured goods with agriculture and mineral products (and oil) making up less than 20% of world trade. Even developing countries now export primarily manufactures. In contrast, a century ago, more trade was in primary products as nations tended to trade for things that literally could not be grown or found at home. Today, the reasons for trade are more varied and the products we trade are ever changing (for example, the rise in trade of things like call centers). The chapter concludes by focusing on one particular expansion of what is “tradable”the increase in services trade. Modern information technology has greatly expanded what can be traded as the person staffing a call center, doing your accounting, or reading your X-ray can literally be half-way around the world. While still relatively rare, the potential for a large increase in service outsourcing is an important part of how trade will evolve in the coming decades. The next few chapters will explain the theory of why nations trade. Answers to Textbook Problems1. We saw that not only is GDP important in explaining how much two countries trade, but also, distance is crucial. Given its remoteness, Australia faces relatively high costs of transporting imports and exports, thereby reducing the attractiveness of trade. Since Canada has a border with a large economy (the U.S.) and Australia is not near any other major economy, it makes sense that Canada would be more open and Australia more self-reliant.2. Mexico is quite close to the U.S., but it is far from the European Union (EU). So it makes sense that it trades largely with the U.S. Brazil is far from both, so its trade is split between the two. Mexico trades more than Brazil in part because it is so close to a major economy (the U.S.) and in part because it is a member of a free trade agreement with a large economy (NAFTA). Brazil is farther away from any large economy and is in a free trade agreement with relatively small countries.3. No, if every countrys GDP were to double, world trade would not quadruple. One way to see this using the example from Table 2-2 would simply be to quadruple all the trade flows in 2-2 and also double the GDP in 2-1. We would see that the first line of Table 2-2 would be, 6.4, 1.6, 1.6. If that were true, Country A would have exported $8 trillion which is equal to its entire GDP. Likewise, it would have imported $8 trillion, meaning it had zero spending on its own goods (highly unlikely). If instead we filled in Table 2-2 as before, by multiplying the appropriate shares of the world economy times a countrys GDP, we would see the first line of Table 2-2 reads, 3.2, 0.8, 0.8. In this case, 60% of Country As GDP is exported, the same as before. The logic is that while the world GDP has doubled, increasing the likelihood of international trade, the local economy has doubled, increasing the likelihood of domestic trade. The gravity equation still holds. If you fill in the entire table, you will see that where before the equation was 0.1 GDPi GDPj, it now is 0.05 GDPi GDPj. The coefficient on each GDP is still one, but the overall constant has changed.4. As the share of world GDP which belongs to East Asian economies grows, then in every trade relationship which involves an East Asian economy, the size of the East Asian economy has grown. This makes the trade relationships with East Asian countries larger over time. The logic is similar for why the countries trade more with one another. Previously, they were quite small economies, meaning that their markets were too small to import a substantial amount. As Overview of Section II: International Trade Policy 11they became more wealthy and the consumption demands of their populace rose, they were each able to import more. Thus, while they previously had focused their exports to other rich nations, over time, they became part of the rich nation club and thus were targets for one anothers exports. Again, using the gravity model, when South Korea and Taiwan were both small, the product of their GDPs was quite small, meaning despite their proximity, there was little trade between them. Now that they have both grown considerably, their GDPs predict a considerable amount of trade.5. As the chapter discusses, a century ago, much of world trade was in commodities that in many ways were climate or geography determined. Thus, the UK imported goods that it could not make itself. This meant importing things like cotton or rubber from countries in the Western Hemisphere or Asia. As the UKs climate and natural resource endowments were fairly similar to those in the rest of Europe, it had less of a need to import from other European countries. In the aftermath of the Industrial Revolution, where manufacturing trade accelerated and has continued to expand with improvements in transportation and communications, it is not surprising that the UK would turn more to the nearby and large economies in Europe for much of its trade. This is a direct prediction of the gravity model.Overview of Section II: International Trade Policy 12Chapter 3Labor Productivity and ComparativeAdvantage: The Ricardian Model Chapter OrganizationThe Concept of Comparative AdvantageA One-Factor EconomyProduction PossibilitiesRelative Prices and SupplyTrade in a One-Factor WorldBox: Comparative Advantage in Practice: The Case of Babe RuthDetermining the Relative Price after TradeThe Gains from TradeA Numerical ExampleBox: The Losses from Non-TradeRelative WagesMisconceptions about Comparative AdvantageProductivity and CompetitivenessThe Pauper Labor ArgumentExploitationBox: Do Wages Reflect Productivity?Comparative Advantage with Many GoodsSetting Up the ModelRelative Wages and SpecializationDetermining the Relative Wage with a Multigood ModelAdding Transport Costs and Non-Traded GoodsEmpirical Evidence on the Ricardian ModelSummaryOverview of Section II: International Trade Policy 13 Chapter OverviewThe Ricardian model provides an introduction to international trade theory. This most basic model of trade involves two countries, two goods, and one factor of production, labor. Differences in relative labor productivity across countries give rise to international trade. This Ricardian model, simple as it is, generates important insights concerning comparative advantage and the gains from trade. These insights are necessary foundations for the more complex models presented in later chapters.The text exposition begins with the examination of the production possibility frontier and the relative prices of goods for one country. The production possibility frontier is linear because of the assumption of constant returns to scale for labor, the sol
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